New approach in analyzing forex markets

It should be clear by now that we are in an era where reliance on traditional approaches to analyzing currency markets is not sufficient in predictive effectiveness. In previous periods (pre-2008 collapse), technical and fundamental analyses were reliable methods for shaping currency trades. Forex traders could be in positions for days and even weeks. Today’s markets are different. Central Bank monetary policies are punctuating price patterns and steering currency valuations. As a result, all eyes of market traders have been focusing on whether quantitative easing will continue. The consequence for traders has been a significant weakening of the value of both traditional technical and fundamental analytical approaches as predictive tools. Let’s look closer at this conclusion.

Those traders who focus on price action are “chartists,” and believe the price patterns hold the key to predicting. Those who focus on forces that move the prices are “fundamentalists,” who believe economic forces such as interest rates, GDP, purchasing power and money supply provide the predictive variables for price direction. But there is an emerging third way we can call “sentiment analysis.” Sentiment analysts believe that each week the market resets expectations and fears. Technical patterns of previous weeks become discounted as new concerns and upcoming event risks increase in their relevance. As each week begins, a new rebalance of fears holds the key to more accurate prediction. Sentiment analysis uses a wide set of tools and tries to detect market emotions and crowd behavior as guides to price direction. The challenge, according to the sentiment analysis mind-set, is not to predict prices, but to fade or follow the crowd. Sentiment indicators include traditional put/call ratios and the set of VIX indicators, but also the innovative tools such as text mining, word clouds and headline analysis. These provide sentimentalists powerful tools for winning the battle of prediction.

A classic example was the cover of The Economist magazine on Oct. 1, 2012. The cover shouted: “Be Afraid,” and came out at the height of the Greek sovereign debt anxiety.

It is no coincidence that the DAX bottomed out with the appearance of this most scary cover. It was a classic contrarian indicator, demonstrating that traders can observe market emotions beyond chart analysis.

A more recent example in which sentiment analysis has trumped both technical and fundamental analysis is the USD/JPY price action. Fundamental analysts have looked to the deflationary conditions that have endured for more than a decade in Japan. They have argued that the BOJ should be changing policy to encourage expansion. But they had no clue as to when to buy USD/JPY. Technical traders saw a major breakout signal to buy the USD/JPY when it broke 80. However, they have been challenged by sell-offs since then. Both these approaches essentially are looking in the rear view mirror.

In contrast, sentiment analysts looked to the election of Japan’s Prime Minister Shinzo Abe and the emergence of “Abenomics” as a strong signal that weakening of the yen was at hand. The parabolic pattern in the rise of the search frequency of the word “Abenomics” is highly coincident with the rise of the USD/JPY.

A major case in point for the value of sentiment analysis in currency trading was the week of April 5. On the Monday and Tuesday before the Wednesday BOJ meetings, the USD/JPY sharply strengthened because the “crowd” feared that the BOJ would not stimulate enough. The crowd was wrong and the USD/JPY surged on the “surprise news” of the huge 7.4 trillion yen ($1.4 trillion) purchases of bonds. The USD/JPY experienced a three-day, 6.4% surge that hadn’t happened since 1988. Technical and fundamental analysts were surprised. But from a sentiment point of view the parabolic path of Abenomics in Google Trends had already generated a signal.

Increasingly in today’s world, predicting price direction is really about predicting where traders are going. Fading or following that crowd is the ultimate decision challenge for the trader. Technical analysis of crowd behavior in markets is at an early stage in its development. But it will become a major third way of understanding markets.

About the Author

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.